The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Tuesday, September 10, 2013

Bank of England to develop secret warning system to prevent bank collapse

The Telegraph reports that the Financial Stability Board has called on the Bank of England to develop a "secret warning system" to communicate to banks without telling investors and depositors that the banks are in danger of failing and need to raise capital.

A secret warning system highlights everything that is wrong with technocratic financial regulation and the substitution of complex rules and regulatory oversight for transparency and market discipline.

The whole idea behind a secret warning system is to keep from market participants knowledge about what the true condition of the bank is.

Effectively, the regulators are lying in the belief that this protects the safety and soundness of the financial system. This lying violates and undermines the FDR Framework on which our financial system is based.

Under the FDR Framework, governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants are given an incentive to use this information as they are responsible for all losses on their exposures.

Isn't the fact that a bank is in danger of failing useful, relevant information?

By conspiring with the banks to hide useful, relevant information, the financial regulators create a moral obligation to bailout the investors in the bust bank.

How can you make an investor take a loss when the government is hiding the information needed to make a fully informed investment decision?

Answer is you cannot. This is why bailing out banks has proven irresistible to financial regulators.

By not ensuring transparency, financial regulators create another problem: banks are not subject to market discipline. There is no market discipline when investors do not have the information they need to independently assess the risk of a bank and adjust their exposure to the bank to what they can afford to lose given this level of risk.

When banks are not subject to market discipline, there is no restraint placed on them as they increase their risk and increase their chances of going bust. If there is transparency, market participants can restrain risk taking by increasing the cost of funds to a bank to reflect an increase in risk.

Since before the financial crisis began, your humble blogger has been saying that we need to bring transparency to all the opaque corners of the financial system.

If there were transparency, financial regulators would directly add their voice in support of market discipline to keep banks from failing. There would be no need for subtle suggestions to banks to raise more capital or lying to market participants.

The Bank of England needs to develop a secret warning system to tell struggling banks they are about to go bust, the global financial regulator has said.

The Financial Stability Board, which is chaired by Bank Governor Mark Carney, has urged Britain’s regulators to find a way round disclosure rules that would complicate an instruction to raise capital or take other remedial action.

Under the Bank’s “proactive intervention framework” (PIF), the Prudential Regulation Authority (PRA) will rate each bank’s “proximity to failure”.

However, “the PRA has decided not to disclose the PIF rating to the firm concerned in order to avoid a situation in which the firm would then have to publicly disclose the rating,” the FSB noted.

A public disclosure that the regulator believed a bank was close to collapse would potentially cause a calamitous collapse in confidence that would itself result with the lender’s failure.

If there were transparency, market participants would know the current condition of each bank and therefore a public disclosure would not trigger a calamitous collapse in confidence.

Furthermore, the experience of Ireland, Greece, Cyprus, Spain and Portugal shows that with deposit insurance in place there are limited bank runs when everyone knows the banks to be insolvent.

However, the FSB said it was necessary for the regulator to ensure banks were “aware of any heightened concerns and accompanying intervention activities”. In order to do so, the PRA “should explore options to disclose the PIF rating to such firms without triggering public disclosure”.

FSB doesn't see a problem with the failure to disclose all useful, relevant information in an appropriate, timely manner.

A clear sign of financial regulators having lost track of their primary responsibility under the FDR Framework.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.